University of California, Los Angeles (UCLA); National Bureau of Economic Research (NBER)

Date Written: October 2, 2015

Abstract

Capital structure theories typically assume liquidation values are exogenous even though they may be determined in part by the debt choices of firms in the industry (Shleifer and Vishny, 1992; Pulvino, 1998). We develop a model in which high industry debt leads to a greater supply of assets for sale by distressed firms but also lower demand for assets from relatively healthy firms because of debt overhang. Thus, high industry debt lowers expected asset liquidation values and provides an incentive for individual firms to take on less debt to take advantage of attractive future buying opportunities. The indirect effect of equilibrium asset prices tempers, and sometimes reverses, the effect of parameters on optimal capital structure choices compared to models with exogenous prices.

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